A Detailed Diversification Strategy: Part II - The Aggressive Investor

Overview

In Part I of this article, I took a look at diversification strategies suitable for risk-averse investors based on different factors such as years from retirement and the size of the investment.

For Part II, I'm going to flip the coin and take a look at suitable diversification strategies for aggressive investors. While Part I was focused on overall asset allocation, Part II will be divided into two sections. The first section will be brief and focus on asset allocation. The second section will focus specifically on stock portfolios and diversification strategies in regards to stock type, market cap, sectors and global regions.

A brief description of what diversification is and whether or not diversification is necessary were both outlined in Part I of the article, so I don't want to rehash that here. But I do want to reiterate a few notes to keep into consideration while reading this article.

A Few Notes

For working investors, before investing in anything else, I think it wise to max out 401(k) and/or IRA contributions (especially when a company match is included).

Many 401(k) plans have limited choices in terms of available funds/investments to contribute. For the purposes of this article, I will assume no such limits, presuming one can adjust individual plans based on the types of funds/stocks available to them.

For the purposes of this article, I will consider all "investments" as indefinitely investable, meaning money from these investments will not be needed in the short term for common household expenses or emergencies (such as a broken furnace, etc.).

I will focus on four classes of assets 1) stocks, 2) commodities, 3) fixed income assets, and 4) cash and cash equivalents. I understand that other investments such as real estate, art and collectibles will fit into the portfolios of some. But I feel the majority of investors focus on the four asset classes mentioned above.

Suggestions/recommendations I give for specific sectors, market caps, etc. will focus on individual stocks, not funds.

SECTION I - ASSET ALLOCATION

Aggressive Investor

By definition, aggressive investors are more open to risk than conservative or balanced investors. This is because they are more concerned with maximizing possibilities of high long-term returns rather than worrying about short-term losses. While conservative investors rely more on fixed income instruments and capital preservation, aggressive investors often focus on equities and capital appreciation.

Just because aggressive investors are open to risk doesn't mean they necessarily enjoy it. Aggressive investors can help achieve their goal of maximizing returns by maintaining a high level of diversification. Even with a concentration on equities, I feel that it is important for aggressive investors to maintain various levels of other asset classes within their portfolio as well.

20+ Years Until Retirement

This group includes investors with 20 or more years remaining before planned retirement. This group will be the most open to risk as they have a long period of time to make gains. For aggressive investors in this category, the vast majority of their portfolio will consist of equities.

A portfolio for this group of aggressive investor might look like this:

(click to enlarge)

I feel like this is a nice allocation to help aggressive investors maximize possible returns by focusing heavily on equities. Stock portfolio allocations will be outlined in section II of this article.

For fixed income, aggressive investors will want to focus specifically on high-yield bonds. I would suggest a mixture of investment grade, and speculative bonds.

For commodities, there are various ways in which investments can be made. For individual investors, the most common options are investing in the actual commodity (such as buying physical gold or silver bars/coins) or investing in a commodity ETF. I suggest investing in a combination of both.

When buying actual commodities, shop around and look for reputable companies that offer prices closest to spot price. When investing in a commodity ETF, make sure to look at past performance as well as expense ratios.

10 to 20 Years Until Retirement

This group includes investors with 10 to 20 years remaining before planned retirement. This group will still want to focus on equities, but will begin moving more income into other assets to avoid large exposures to long-term losses.

A portfolio for this group of aggressive investor might look like this:

(click to enlarge)

I feel that this is an appropriate allocation for aggressive investors as it still keeps the focus on capital appreciation but increases exposure to income-oriented assets, which will become more important as retirement nears.

In looking at the chart, you can see that still only 5% of the investor's investable income is allocated towards cash and/or cash equivalents. For an aggressive investor, I feel that this percentage is warranted, but want to reiterate that this is just a general model. There will be specific times in which individual investors will want to increase or reduce their exposure to cash based on the current market environment.

5 to 10 Years Until Retirement

This group includes investors with 5 to 10 years remaining before planned retirement. This time period still gives investors plenty of time to acquire capital appreciation but may begin to give investors pause as they do not want to be exposed to a long-term bear market.

A portfolio for this group of aggressive investors might look like this:

(click to enlarge)

I feel like this is an appropriate allocation for investors in this time bracket as it keeps just over half of assets in stocks, but spreads out nearly half of the remaining assets through other categories with a strong focus on generating income.

1 to 5 Years Until Retirement

This group includes investors with 1 to 5 years remaining before planned retirement. As retirement draws close, aggressive investors will not focus nearly as much on capital appreciation, but instead focus on keeping the maximum returns they have earned over the years while still generating income from their combined assets.

A portfolio for this group of aggressive investors might look like this:

(click to enlarge)

I feel like this is an appropriate allocation as it still allocates and focuses 50% (through equities and commodities) of an investor's assets on capital appreciation, while now focusing the other 50% on capital preservation. With retirement right around the corner, I feel like this is an appropriate mix for an aggressive investor.

As retirement approaches, investors will not only want to change their asset allocations but also change the individual investments within those asset categories. For example, an investor 1 year from retirement will probably focus more heavily on short-term municipal or investment grade bonds, where an investor 15 years away from retirement may focus more on speculative bonds.

Section II will focus on the diversification of an investor's stock portfolio and some of the changes he or she may make to individual investments as retirement draws near.

SECTION II: STOCK PORTFOLIO DIVERSIFICATION

Diversifying your stock portfolio can be a daunting task. There are several ways in which you can diversify. You can look at stock types, market sectors, market caps, locations, etc. I'm going to take a look at several of these areas and give what I feel are appropriate allocations for an aggressive investor and give recommendations on what I feel to be solid stock picks.

One of the easiest ways to diversify is to use funds. However, for examples/recommendations in this article I will be looking at individual stocks only, even though I believe funds are a great investing tool.

Stock Size

Having stocks of varying sizes is one way in which you can diversify your portfolio. History has shown that smaller stocks have performed better on average over long periods of time compared to larger companies. However, during recessions and bear markets it is often the larger companies that retain more of their value.

MEGA CAP - These are stocks that have more than $200 billion in assets. Companies in this category that I like are General Electric (NYSE:GE), Johnson & Johnson (NYSE:JNJ), Procter & Gamble (NYSE:PG) and Exxon (NYSE:XOM).

LARGE CAP - These are stocks that have between $10 billion and $200 billion in assets. Companies in this category that I like are American Express (NYSE:AXP), Disney (NYSE:DIS), 3M (NYSE:MMM) and AT&T (NYSE:T).

MID CAP - These are stocks that have between $1 billion and $10 billion in assets. Companies in this category that I like are Cooper Tire & Rubber (NYSE:CTB), Foot Locker (NYSE:FL) and Nvidia (NASDAQ:NVDA).

SMALL CAP - These are stocks that have between $300 million and $1 billion in assets. Companies in this category that I like are WD-40 (NASDAQ:WDFC), PetMed Express (NASDAQ:PETS), Carmike Cinemas (NASDAQ:CKEC) and American Greetings (NYSE:AM-OLD).

MICRO CAP - These are stocks that have between $50 million and $300 million in assets. Companies in this category that I like are Crown Crafts (NASDAQ:CRWS), Gas Natural (NYSEMKT:EGAS), Cherokee (NASDAQ:CHKE) and Friedman Industries (NYSEMKT:FRD).

NANO CAP - These are stocks that have less than $50 million in assets. I personally don't invest in or follow Nano Cap stocks often so I don't have any recommendations for this category.

For an aggressive investor, an appropriate stock portfolio allocation in my opinion based on stock size would be:

(click to enlarge)

I feel like this is an appropriate allocation as it focuses more than 50% of assets on small-cap and mid-cap stocks, which should be high-growth opportunities. As an investor gets closer to retirement he/she will want to adjust these percentages and probably focus more on mega cap/large cap and shift away from the more volatile nano/micro cap stocks.

Stock Sector

Another way in which you can diversify your account is by looking at stock sectors. There are many different ways in which you can break down or divide stock sectors (I've seen as many as 30 different sectors defined), but for this article I will use the S&P classifications, which includes 10 different sectors.

First, let's take a look at the non-cyclical sectors. These are often referred to as defensive sectors as they have a history of holding up better during tough economic times. These include:

Consumer Staples - This sector includes companies that develop, manufacture, and distribute consumer products such as food, household products, soft drinks and cosmetics. Companies that I like in this sector include General Mills (NYSE:GIS), Procter & Gamble, Hormel Foods (NYSE:HRL), and Hershey (NYSE:HSY).

Healthcare - This sector includes pharmaceutical companies, healthcare providers, and companies that produce and distribute medical devices and supplies. Companies that I like in this sector include WellPoint Inc. (WLP), UnitedHealth Group (NYSE:UNH), Cerner Corporation (NASDAQ:CERN), and Herbalife (NYSE:HLF).

Utilities - This sector includes companies that provide electricity, gas, or water products and/or services. Companies that I like in this sector include Southern Company (NYSE:SO), Black Hills Corporation (NYSE:BKH), Wisconsin Energy Corporation (NYSE:WEC), and Northeast Utilities (NU).

Now, let's take a look at the cyclical sectors. These sectors have a very strong correlation with the current economic environment. These include:

Consumer Discretionary - This sector includes companies that develop, manufacture and distribute consumer products that are not deemed as necessary. Airlines, auto manufacturers, restaurants, toy makers, and publishing companies are examples that fit into this sector. Companies that I like in this sector include Disney, Ford (NYSE:F), Stanley Black & Decker (NYSE:SWK) and Hasbro (NASDAQ:HAS).

Energy - This sector includes companies that produce and distribute coal, oil, and natural gas. Companies that I like in this sector include Kinder Morgan (NYSE:KMI), National Oilwell Varco (NYSE:NOV), Pengrowth Energy (NYSE:PGH) and Renewable Energy Group (NASDAQ:REGI).

Financials - This sector includes banks, insurance companies, and real estate firms. Companies that I like in this sector include Wells Fargo (NYSE:WFC), City Holding Company (NASDAQ:CHCO), Aflac (NYSE:AFL) and Liberty Property Trust (LRY).

Industrials - This sector includes companies that manufacture, service or transport industrial products. Companies that I like in this sector include 3M, Raven Industries (NASDAQ:RAVN), Danaher Corporation (NYSE:DHR) and W.W. Grainger (NYSE:GWW).

Information Technology - This sector includes companies that develop, manufacture and distribute technology hardware/software, semiconductors, and communication products. Companies that I like in this sector include Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL), IBM (NYSE:IBM) and Intel (NASDAQ:INTC).

Basic Materials - This sector includes companies that are commodity driven. They are companies involved in the mining, production, and distribution of lumber, paper, metals, and chemicals. Companies that I like in this sector include Rio Tinto (NYSE:RIO), PPG Industries (NYSE:PPG), Alcoa (NYSE:AA) and Dow Chemical (NYSE:DOW).

Telecommunication Services - This sector includes companies that are involved in providing fixed line or wireless communication services. Companies that I like in this sector include AT&T, Verizon (NYSE:VZ), CenturyLink (NYSE:CTL) and Qualcomm (NASDAQ:QCOM).

One additional sector that I want to include is Conglomerates. These are huge companies that provide products and/or services that stretch across several sectors. Companies in this sector that I like include Textron (NYSE:TXT), General Electric, Honeywell International (NYSE:HON) and Crane Company (NYSE:CR).

For true diversification, an investor should have a pretty even distribution across all sectors, with the allocation looking something like:

(click to enlarge)

While this is definitely diversified, I'm not sure how realistic it is. This is one area in which I feel investors will want to review and update their allocations periodically based on market environments. For example, if the telecommunications sector is forecast to have negative overall growth over the next five years, you may want to reduce your position in that sector and focus on a sector with a higher forecast prediction. This is especially true for aggressive investors who want to maximize returns.

Geography

When looking at the geography of a stock, there are two main classifications to look at. Is the company in a developed market or an emerging market? An investor will want to have a mix of both in their portfolio.

Developed Markets - Developed markets are thought to be less risky, but often also provide fewer growth opportunities than emerging markets. Countries in developed markets include the United States, Canada, Australia, Hong Kong, Israel, Japan, and a large number of countries throughout Europe.

I believe that even aggressive investors should invest considerably in U.S. stocks. Because of this an allocation that I think is reasonable for an aggressive investor based on geography would look like this:

(click to enlarge)

A detailed look at what this allocation might look like is shown in the table below. The table consists of companies that I like and represents a sample portfolio of 25 stocks.

If you are someone who doesn't want to invest in foreign stocks, an alternative to this type of diversification is to invest in companies that create a large percentage of their revenue from countries outside the United States. General Electric, Exxon Mobil, Coca-Cola (NYSE:KO), and IBM all create over half of their sales from foreign markets, including several emerging markets.

Type of Stock

There are several different types of stocks. I've already classified several types of stocks based on market cap, sector, and geography. Now, I'm going to focus on the type of stock related to its overall purpose. And I am going to focus on three types: 1) Growth Stocks 2) Income Stocks, and 3) Value Stocks.

Growth Stocks - The purpose of a growth stock is growth. When investing in growth stocks, investors are looking for appreciation in the price of the stock. When growth stops, the stock is no longer a growth stock. Apple is a good example of this. Some believe that it is still a growth stock, while others believe the majority of Apple's growth is behind it.

Income Stocks - The purpose of an income stock is income. Investors in income stocks are not as concerned with the price of the stock, but rather focus priority on the stock's dividend. Utilities are one of the most well known income stock types as they often have little room for growth but often pay steady and attractive dividends.

Value Stocks - The purpose of value stocks is value. Investors invest in value stocks because they believe the market has currently undervalued these companies. Investors in value stocks are often long-term investors as they wait for the market to realize a company's true value and realize an increase in stock price.

For a diversified portfolio, investors will want to invest in a combination of all three stocks. Aggressive investors will want to focus a large majority of their allocation on growth stocks. However, depending on current market conditions and length of time from retirement, investors will want to review and update these allocations to try and maximize possible long-term returns.

Conclusion

Diversification means different things to different people. For some, diversification is as simple as investing in more than one thing. For others, diversification means investing in items that have a negative correlation. If investment A increases, investment B decreases and vice versa. For me, diversification is not a single, simple idea or plan.

Several factors should be considered when deciding on a diversification plan for your retirement portfolio. The number one consideration, in my opinion, is to determine what type of investor you are. While this part of the article covered an aggressive investor with an emphasis on an investor's stock portfolio, a conservative investor will have a quite different approach.

However, several of the questions to consider will be the same across all sectors. What assets should I invest in? What size of stocks should I invest in? What sectors should I invest in? What types of stocks should I invest in? Should I invest in international stocks?

The answers to these questions will be different for each individual investor, but the underlying principles surrounding these questions will be similar.

I feel that I have detailed a comprehensive foundation for an aggressive investor to build their diversified retirement portfolio on. I do want to reiterate that diversifying just for the sake of investing in something different is a losing strategy. When making investment choices based on market cap, sector, region, etc. make sure that you are investing in solid companies. Without that, diversification will be of little use.

I plan on posting the final section of this article, part III, in the coming weeks and it will focus on a diversification strategy for a balanced investor.

Disclosure: I am long F, GE, PGH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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